How blockchain could fix the supply chain fraud problem

Blockchain is set to disrupt supply chains, but could it prevent fraud problems like the Salad Oil Swindle of 1963? Actually, yes it could

I’m not sure if you’re supposed to have a favorite supply chain fraud or not. But I do, and it is the famous case of the vegetable oil that almost bankrupted American Express (and went some way toward making Warren Buffet a multi-billionaire).

The essence of the story is that a conman, Anthony “Tino” De Angelis, discovered that people would lend him money on the basis of commodities in the supply chain. His chosen commodity was vegetable oil (see How The Salad Oil Swindle Of 1963 Nearly Crippled The NYSE). Amex had a division that made loans to businesses using inventories as collateral. They gave De Angelis financing for vegetable oil and he took the Amex receipts to a broker who discounted them for cash. So he had tanks of vegetable oil and Amex had loaned him money against the value of the oil in those tanks, the idea being that they would get the money back with a bit extra when the oil was sold on.

Now as it happened, the tanks didn’t much contain oil at all. They were mostly water with a layer of oil on top so that when the inspectors opened the tanks and looked inside they saw oil and signed off whatever documentation was required. Eventually the whole scam blew up and nearly took Amex down, enabling the sage of Omaha to buy up their stock and make a fortune.

Fortunately for us, and unfortunately for conmen like Tino, the supply chain is one of the many industries that the blockchain is going to disrupt. As my good friend Michael Casey and his co-author Pindar Wong explain in their recent Harvard Business Review piece on the topic (Global Supply Chains are about to get Better, Thanks to Blockchain in HBR, 13th March 2017), blockchain technology allows computers from different organizations to collaborate and validate entries in a blockchain. This removes the need for error prone reconciliation between the different organization’s internal records and therefore allows stakeholders better and timelier visibility of overall activity. The idea discussed in this HBR piece (and elsewhere) is that some combination of “smart contracts” and tagging and tracing will mean that supply chains become somehow more efficient and more cost-effective.

[An aside: I put “smart contracts” in quotes because, of course, they are not actually contracts. Or smart. Bill Maurer and DuPont nailed this in their superb King’s Review article on Ledgers and Law in the Blockchain (22nd June 2015), where they note that smart contracts are not contracts at all but computer programs and so strictly speaking just an “automaticity” on the ledger. (Indeed, they go on to quote Ethereum architect Vitalik Buterin saying that “I now regret calling the objects in Ethereum ‘contracts’ as you’re meant to think of them as arbitrary programs and not smart contracts specifically”.)]

Using the blockchain and “smart contracts” sounds like an excellent idea, and there’s no doubt that supply chain participants are taking this line of thinking pretty seriously. Foxconn (best known as the makers of the iPhone) are a recent case study. In March 2017 they demonstrated a blockchain prototype that they used to loan more than $6 million to suppliers. I should note in passing that the article didn’t make it clear why they were using a blockchain (as opposed to any other form of shared ledger) or why they were using a shared ledger rather than a database but, like Merck and Walmart and many others, Foxconn is a serious business that sees promise in the technology, so we should take the case study seriously.

Knowing pork from platypus

While I was reading about Foxconn, and a couple of other related articles in connection with a project for a client, I started to wonder just how exactly would the supply chain industry be disrupted? How would the blockchain have fixed the salad oil problem? It’s very easy to think of a fancy FinTech setup whereby smart contracts took care of passing money from the lender to the conman when the tanks were certified by the inspectors, but as skeptical commentators (e.g., the redoubtable Steve Wilson of Lockstep) frequently point out, transactions using blockchain technology are only “trustless” insofar as they relate to assets on the blockchain itself. As soon as the blockchain has to be connected to some real-world asset, like vegetable oil, then it is inevitable that someone has to trust a third-party to make that connection.

Trusting these third parties can be a risk. Another of my favorite scandals (I have quite a few, I should have mentioned that) is the horsemeat scandal that swept Europe on the 50th anniversary of the salad oil scandal. Basically horsemeat was being mixed with beef in the supply chain and then sold on to the suppliers of major supermarkets in, for example, the UK. One of the traders involved was sentenced to jail for forging labels on 330 tons of meat as being 100% beef when they were not. Once again, I am curious to know how a blockchain would have helped the situation, since the enterprising Eastern European equine entrepreneur would simply have digitally-signed that the consignment of donkey dongs were Polish dogs and no-one would have been any the wiser. It is not clear how a FinTech solution based on blockchains and smart contracts would have helped, other than to make the frauds propagate more quickly.

The reason that I am interested in scandals like this one is that the tracking of food features is one of the main supply chain problems that advocates hope the blockchain will solve for us. Work is already underway in a number of areas. I understand that Walmart have carried out some sort of pilot with IBM to try to track pork from China to the US, and another pilot was used to track tuna from Indonesia to the US. But if someone has signed a certificate to say that the ethically-reared pork is actually tuna, or whatever, how is the shared ledger going to know any different? A smart contract that pays the Chinese supplier when the refrigerated pork arrives in a US warehouse, as detected by RFID tags and such like, has no idea whether the slabs in the freezer are pork or platypus.

If you do discover that it’s platypus, then I suppose you could argue that the blockchain provides an immutable record that will enable you to track back along the supply chain to find out where it came from. But how will you know when or where the switcheroo took place? Some of the representations of the blockchain’s powers are frankly incredible, but it isn’t magic. It’s a data structure that recapitulates the consensus of its construction, not a Chain of True Seeing with +2 save against poison. So is there any point in considering a form of shared ledger technology (whether a blockchain or anything else) for this kind of supply chain application?

Well, yes. We think there is.

Partial transparency

Let’s go back to the first example, the great vegetable oil swindle. Had American Express and other stakeholders had access to a shared ledger that recorded the volumes of vegetable oil being used as collateral, the fraud would have been easily discovered.

“If American Express had done their homework, they would have realized that De Angelis’s reported vegetable oil ‘holdings’ were greater than the inventories of the entire United States as reported by the Department of Agriculture. “

Interesting. So if the amounts of vegetable oil had been gathered together in one place, the fraud would have been noticed. What could that one place be? A federation of credit provider’s databases? A shared service operated by the regulator? Some utility funded by industry stakeholders? How would they work? What if the stakeholders, instead of paying some third party to run such a utility, used a shared ledger for their own use? It would be as if each market participant and regulator had a gateway computer to a central utility, except that there would be no central utility. The gateways would talk to each other, and if one of them failed for any reason, it would have no impact on the others. That sounds like an idea to explore further.

How might such a ledger might operate? Would American Express want a rival to know how much vegetable oil it had on its books? Would it want anyone to know? The Bank of Canada, in their discussion of lessons learned from their first blockchain project, said that “in an actual production system, trade-offs will need to be resolved between how widely data and transactions are verified by members of the system, and how widely information is shared”. In other words, we have to think very carefully about what information we put in a shared ledger and who is allowed to say whether that information is valid or not. Luckily, there are cryptographic techniques known as “Zero Knowledge Proofs” (ZKPs) that can deliver the apparently paradoxical functionality of allowing observers to check that ledger entries are correct without revealing their contents and these, together with other well-known cryptographic techniques, are what allow us to create a whole new and surprising solution to the problem of the integrity of private information in a public space.

It is clear from this description that a workable solution rests on what Casey and Wong call “partial transparency”. At Consult Hyperion we agree, and we borrowed the term translucency from Peter Wagner for the concept. For the past couple of years, we have used a narrative built around this to help senior management to understand the potential of shared ledger technology and form strategies to exploit it. Indeed, in some contexts we focus on translucent transactions as the most important property of shared ledgers and as a platform for new kinds of marketplaces that will be cheaper and safer, a position that you can find explored in more detail in the paper that I co-authored with my colleague Salome Parulava and Richard Brown, CTO of R3CEV. (See: “Towards ambient accountability in financial services: shared ledgers, translucent transactions and the legacy of the great financial crisis”, Journal of Payment Strategy and Systems10(2): 118-131 (2016).)

As you might deduce from the title, in this paper we co-opt the architectural term “ambient accountability” to describe the combination of practical Byzantine fault tolerance consensus protocols and replicated incorruptible data structures (together forming “shared ledger” technology) to deliver a transactional environment with translucency. As Anthony Lewis from R3CEV describes in an insightful piece on this new environment, it is much simpler to operate and regulate markets that are built from such structures.

The reconciliation comes as part of the fact recording; not after. Organizations can “confirm as they go”, rather than recording something, then checking externally afterwards.

In this way the traditional disciplines of accounting and auditing are dissolved, re-combined and embedded in the environment. Smart contracts wouldn’t have disrupted Tino’s business, but ambient accountability would have uncovered his plot at a much earlier stage, when the near real-time computation of vegetable oil inventories would delivered data on his dastardly plot. You’d hardly need Watson to spot that inventories greater than the United States entire annual production ought to be looked into in more detail.

Shared ledger as RegTech

Perhaps we need to shift perspective. It is the industry-wide perspective of the shared ledger, the shared ledger as a RegTech, that makes the disruptive difference to supply chains, just as it is the shared ledger as a RegTech that will reshape financial markets by creating environments for faster, cheaper and less opaque transactions between intermediaries that have to add value to earn their fees rather than rely on information asymmetries to extract their rent. As the World Economic Forum’s report on the Future of Financial Services [PDF] says, “New financial services infrastructure built on [shared ledgers] will redraw processes and call into question orthodoxies that are foundational to today’s business models”. We agree.

Incidentally, the brilliant Maya Zahavi from QED-it will be explaining how ZKPs can transform supply chains at the 20th annual Consult Hyperion Tomorrow’s Transactions Forum on April 26th and 27th in London. Run, don’t walk, over to that link and sign up now for one of the few remaining delegate places and to be kept up-to-date in the future, sign up for our mailing list as well.

[Sincere thanks to my colleague Tim Richards and to my former colleague Salome Parulava for their helpful comments on an earlier draft of this post.]

Dave is Director of Consult Hyperion, the secure electronic transactions consultancy and is an internationally-recognised thought leader in digital identity and digital money. Named in Wired magazine’s global top 15 favourite sources of business information; rated one of the NextBank “Fintech Titans”; voted one of the European “Power 50” people in digital financial services and ranked Europe’s most influential commentator on emerging payments.

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